Market Segmentation: The Role of Opaque
Travel Agencies
DMITRY SHAPIRO
Belk College of Business
University of North Carolina–Charlotte
9201 University City Boulevard
Charlotte, NC 28223-0001
dashapir@uncc.edu
XIANWEN SHI
Department of Economics
University of Toronto
150 St. George Street
Toronto, ON, Canada M5S 3G7
xianwen.shi@utoronto.ca
This paper investigates the role of discount travel agencies such as Priceline and
Hotwire in the market segmentation of the hotel and airline industries. These
agencies conceal important characteristics of the offered services, such as hotel
locations or flight schedules. We explicitly model this opaque feature and show
that it enables service providers to price discriminate between those customers
who are sensitive to service characteristics and those who are not. Service
providers can profit from such discrimination despite the fact that the opaque
feature virtually erases product differentiation and thus intensifies competition.
The reason is that the intensified competition for less sensitive customers enables
service providers to commit to a higher price for more sensitive customers, which
leads to higher profits overall. This explains why airlines or hotels are willing to
lose the advantage of product differentiation and offer services through discount
travel agencies.
1. Introduction
In the past few years, the emergence of online electronic markets
dramatically changed the leisure travel industry, making it one of the
most developed online businesses. In the United States, online leisure
We are grateful to Mark Armstrong, Danielle Catambay, Stephen Morris, Artie Zillante,
two anonymous referees and an anonymous coeditor whose valuable suggestions helped
us to improve the paper.
C
2008, The Author(s)
Journal Compilation
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2008 Wiley Periodicals, Inc.
Journal of Economics & Management Strategy, Volume 17, Number 4, Winter 2008, 803–837
804 Journal of Economics & Management Strategy
travel bookings more than tripled from 2001 to 2005,
1
and are expected to
reach about $69 billion in 2007, or 35% of all online consumer spending.
2
According to PhoCusWright, an independent consultancy, online leisure
travel bookings in the United States will surpass offline bookings in
volume for the first time in 2007.
3
Expedia (who owns Expedia.com and Hotels.com), Travelocity
and Orbitz are the three dominant online travel agencies (OTAs). Two
niche players, Hotwire.com (acquired by Expedia in 2003) and Price-
line.com, have emerged that offer services with 30–50% price discounts
as compared to offline reservation prices or prices of other OTAs. These
discount agencies have gained sizeable market shares. According to
MarketMetrix, Priceline and Hotwire combined account for 6.7% of
worldwide online hotel bookings in 2006, comparable to Expedia.com
(10.4%), Travelocity.com (6.8%) and Orbitz.com (4.9%).
4, 5
In November
2007, Priceline reported a gross profit of $479 million and gross travel
bookings of $3.6 billion worldwide for the first three quarters (a 58.9%
and 40.6% increase compared to the same period in 2006, respectively).
6
The defining feature of Priceline and Hotwire is that they do not
tell customers certain itinerary details, such as brand, time of flight
departure or exact hotel location, until the transaction is completed, and
thus they are often referred to as “opaque” travel sites.
7
Both sites used
to offer opaque services exclusively, but recently, Priceline (in 2003) and
Hotwire (in 2005) added the traditional transparent retail option with
disclosed prices and itinerary details. Opaque sales nonetheless still
remain a defining identity and major revenue source for both sites. In
2006, for example, Priceline reported that it “represented the substantial
majority of our total revenues.”
8
1. Source: The New York Times (Late Edition [East Coast]). May 30, 2005. p. C.6.
2. Source: http://www.comscore.com/press/release.asp?press=1545. Press release of
comScore.com from July 30, 2007.
3. Source: http://store.phocuswright.com/phuontrovsee.html. PhoCusWright’s U.S.
Online Travel Overview, 2007.
4. Source: MarketMetrics.com, http://marketmetrix.com/en/default.aspx?s=research
&p=research6.
5. These figures likely underestimate the importance of Priceline and Hotwire in the
leisure travel market because they include five-star hotels that are usually not offered by
opaque sites (with the exception of Las Vegas). The figures also include sales in small
cities where it is infeasible for opaque sites to operate—opaque sites need sufficiently
many participating hotels to form an opaque product.
6. Priceline.com 2007 Q3 report, Form 10-Q, p. 23 and p. 26.
7. There is a slight difference between the two sites. Hotwire discloses the prices for
opaque hotels or car rentals so consumers do not bid and simply decide whether to buy
or not. Priceline, on the other hand, asks consumers to “Name Your Own Price” for the
opaque service requested.
8. Priceline.com 2005 annual report Form 10-Q, p. 4, and 2006 annual report, Form
10-Q, p. 2.
Opaque Travel Agencies 805
The opaque feature of Priceline and Hotwire has a strong impact on
the competition between service providers. When the complete informa-
tion about flights (or hotels) is available they are differentiated products.
Hotels differ from each other in their identity, locations and amenities;
flights differ in their departure times, the number of connections, and the
length of layovers. It is well-known that product differentiation reduces
competition and increases prices and profit (Hotelling, 1929). In contrast,
products sold through Priceline and Hotwire are indistinguishable for
customers and become essentially perfect substitutes, which leads to
Bertrand competition and drives down both the price-cost margin and
firms’ profits.
The question is then: why would hotels and airline companies be
willing to sell their products through Priceline or Hotwire and lose the
advantage (and profit) that product differentiation gives them?
One explanation is that firms use OTAs with the opaque feature to
respond to changes in demand without jeopardizing existing branding
and pricing policies (formalized in Wang et al., 2006). Although this may
be a part of the story we believe that this does not capture the whole
picture. First, Priceline and Hotwire offer tickets during peak seasons
(such as Christmas) and to popular destinations where the demand is
traditionally high. Second, the amount of concealed information is more
than the hotel or airline’s identity, which also suggests that the purpose
of these agencies is more than just a facility to anonymously respond to
demand changes.
Another possible explanation is that opaque sites can help sell-
ers reach new consumers with low valuations who otherwise remain
outside the market. The low price of opaque services enables sellers to
attract low value customers who are sensitive to price but less sensitive
to service characteristics. On the other hand, the opaque feature prevents
high value customers from switching to opaque channels because they
would prefer to know itinerary details.
In this paper, we show that opaque agencies enable hotels and
airlines to do much more than just attract low value consumers with
cheap prices. In our model, they act as a “collusion device” to facilitate
price discrimination between different types of customers and increase
overall profits, even when the total market demand is perfectly inelastic.
We study the role of opaque travel agencies by using a variation of
the Hotelling model. A model of horizontal differentiation is appropriate
in this setting because both hotel and airline competitions are among
service providers with similar qualities. First, Priceline and Hotwire
disclose the star-ratings for hotels’ service quality and amenities, so
the competition is largely among hotels with similar qualities. Second,
there is little quality difference among major airlines who provide
806 Journal of Economics & Management Strategy
the substantial majority of tickets to opaque sites.
9
In particular, all
tickets sold through opaque agencies are economy (coach) class only.
Furthermore, Priceline promises that flights have at most one stop each
way, the layover is no longer than 3 hours, and no red-eye or off-peak
flight are offered unless the traveler agrees to take one.
In this paper, we assume that there is a circle-shaped city where
N hotels are located (Salop, 1979). Consumers have two-dimensional
types: location and transportation cost. Consumers’ location type comes
from the standard Hotelling model and is continuous. The transporta-
tion cost is binary—either high or low. We refer to consumers with a
high transportation cost as business travelers, and a low transportation
cost as leisure travelers.
We depart from the standard Hotelling’s framework by explicitly
modeling the opaque feature of Priceline and Hotwire. In our model,
there is a single opaque travel agency that posts hotel prices and
withholds hotel identities. Customers can make a reservation either
via standard (nonopaque) travel agencies, or using the opaque travel
agency. In the former case, customers can choose a specific hotel, and
other things being equal, they would like to stay at the hotel that is closest
to their preferred location. In the latter case, customers do not know the
hotel’s location and they simply prefer the hotel with the lowest price.
For a particular range of parameter values, we show that having
an agency with the opaque feature enables hotels to separate high-type
(business) travelers from low-type (leisure) travelers and to gain from
this separation. The source of this gain comes from price discrimination.
Without the opaque agency, hotels compete for both high and low-
type travelers through nonopaque reservation systems. The presence
of the low-type in this market intensifies the competition and drives
down the equilibrium price and profit. When an opaque travel agency
(like Priceline or Hotwire) is introduced, a new equilibrium arises
where high-type customers prefer to be served by agencies without the
opaque feature and pay a high nonopaque price. Low-type customers, on
the other hand, are served by the opaque agency that charges lower
prices. The competition through the opaque agency is described by a
Bertrand model, and so in the new equilibrium, hotel’s competition for
the low-type increases. However, competition in the more lucrative seg-
ment of the market—high-type travelers—decreases. It is still a Hotelling
competition, but hotels no longer compete for the low-type. Only high-
type customers buy differentiated products and in the equilibrium the
9. The five largest airline suppliers accounted for 82% of total tickets sold at Priceline
in 2006. See Priceline.com 2006 annual report, p. 16.
Opaque Travel Agencies 807
nonopaque price is higher. Consequently, as long as there is a sufficient
number of high-type travelers, firms’ overall profit increases.
Importantly, and perhaps somewhat surprisingly, it is the intensi-
fied competition for the low-type which enables hotels to decrease com-
petition for the high-type. Leisure customers enjoy high surplus when
being charged low opaque prices. To attract them to the nonopaque
sector, a hotel would have to decrease the price too much to be prof-
itable. As a result, in equilibrium hotels can sustain the high price of
the nonopaque sector because they no longer use it to compete for
leisure travelers.
The contribution of our paper is threefold. First, we formally model
the opaque feature of Priceline.com and Hotwire.com and investigate
its impact on the competition of the travel industry. Second, within our
framework we find conditions on the degree of opacity that enables
hotels and airlines to price discriminate using opaque OTAs. We show
that the opacity level cannot be either too high or too low. If the
opacity level is too high, leisure travelers would prefer to use standard
reservation systems, while if the opacity level is too low, business
travelers would find it optimal to purchase the opaque good. This
finding is consistent with the fact that Priceline/Hotwire do not offer
hotel rooms in small towns and divide large cities into zones. Third, our
analysis helps explain why hotels and airlines are willing to use opaque
channels to distribute their products. In particular, we identify the set of
parameters for which the introduction of the opaque agency increases
the overall profits of the industry.
2. Literature Review
In the literature there are only a few papers that focus on the effect
of the opaque feature of Priceline and Hotwire. Most of them, like
Wang et al. (2006), conduct analysis in the monopolistic setting, whereas
we explicitly model the competition in the travel industry. To our
knowledge, Fay (2008) is the only paper that models the opaque feature
in the competitive environment. In his model, there are two firms and
two types of consumers: those who are always loyal to a particular firm,
and those whose preferences are distributed along the line between two
firms as in the Hotelling model. The transportation cost of all consumers
of the second type is the same.
Our paper is different from Fay (2008) in several aspects. First of
all, we consider a more general framework with any number of firms.
Here the number of firms can be interpreted as the degree of opacity
of the products offered by discount agencies. Consequently, we are
